Four Ways to Fail in the Stock Market

The road to successful stock market investing is fraught with hazards. Here are four common traps into which novice investors often fall.

Penny Stock

The principal reason penny stock sells for cents rather than dollars is that the companies represented by these stocks often aren’t worth very much. If they aren’t worth much, why would you buy them? The answer is because they are cheap, which, regrettably, isn’t the best of reasons to buy any stock. I guess it’s human nature. This is the “I’ll take a flyer on that” mentality based on the belief that if the stock fails to appreciate in value, one hasn’t lost very much. This is a counter-productive attitude and is nothing short of gambling. You should buy a stock because the company has value and its earnings potential is high—not because it’s cheap. The fact is many of these stocks are hyped beyond all reason in a desperate attempt to attract investors for the purpose of saving a failing enterprise. Don’t be sucked in! Yes, there are viable penny stocks out there, but you will have to do your homework to find them.

Diversification

This is so important! The market is divided into sectors: consumer goods, pharmaceuticals, financials and healthcare are a few examples. If you have all your investments in any particular sector, your portfolio is at risk. For example, if your stock portfolio consists only of companies that deal in consumer goods and the economy enters a recession, all your stock will likely be adversely affected. Diversifying your investments by buying stock in a variety of sectors helps insulate at least some of money from adverse trends that may affect a single sector. Investors with minimal funds available for investment purposes should turn to mutual funds because they do not have sufficient funds available to invest across a spectrum of sectors. Too often, investors think that diversification means investing in multiple companies, but the reality is that investing in multiple companies in the same sector can devastate you. True diversification means investing across a range of companies in multiple sectors of the market. Most of us can’t afford to do that effectively. If this is true for you, turn to mutual funds to achieve that diversification. It isn’t glamorous, but it is effective.

Chasing Dividends

Don’t get me wrong! Dividends are a wonderful thing. A stock that appreciates in value and pays a hefty dividend is a very good buy. The problem is, too many of us look at the dividend and fail to perform other aspects of due diligence that any investment requires. Selecting a stock based entirely on the dividend is a very dangerous strategy. Actually, it isn’t a strategy at all—it is a mistake. Here are some things to consider.

Look at the payout ratio. As you know, dividends are paid from a company’s earnings. The dividend represents a share of the profits which are paid to shareholders. Dividends are typically paid to shareholders on a quarterly basis. If the company earns $1.50 per share in a given quarter and pays a dividend of $1, that equates to a payout ratio of 66 percent. If the payout ratio is high, it may mean the company isn’t investing in its business, which can have catastrophic results. A company with a payout ratio approaching or exceeding 100 percent bears close scrutiny. Payouts exceeding 100 percent usually signal the company is borrowing to meet the dividend payment. While there is no ideal payout ratio I can quote you, I believe a payout ratio in excess of 70 percent should be closely monitored.

Cashing Out

You may not have considered this, but you don’t make or lose a dime in the stock market until you sell your stock. Up to that point, you are dealing with virtual gains and losses. Even the government refrains from taxing you until the stock is sold. This is why knowing when to sell your stock is so important. This is the point at which the rubber meets the road. Unfortunately, there is no magic formula that will tell you when the optimum moment to sell presents itself. Observing trends, keeping current with events that may affect the value of the stock and common sense are your best allies. All I can tell you is the obvious. If you sell too soon, you may be leaving money on the table. If you sell too late, you are going to lose some of what you could have gained. You need to find a balance between greed and fear. Experience is your best teacher. Just be sure the lesson isn’t too costly.

Have you ever bought penny stocks? What was the result? Have you made mistakes when it comes to investing? Can someone benefit from your experience? We love to hear from readers and hope you will share some of your experiences.

I find very little difference between penny stocks and gambling. I agree that one can get suckered in with hefty gains but like most gamblers, people change to chase their losses and usually come unstuck. I would not recommend trading penny stocks for the inexperienced or uninitiated.